David Herro Market Commentary | 2Q17
June 30, 2017
Both the Oakmark International and International Small Cap Funds performed well in our view in the second quarter of 2017. In fact, the strong performance across our strategies has continued from the post-Brexit rebound that began early in the third quarter of 2016. More importantly, our long-term positive track record remains intact. Please see the individual Fund letters for details.
The Wake of Brexit
A little more than one year ago, citizens of the U.K. voted to leave the European Union. Global equity markets strongly reacted to this decision as the pound sterling dropped and the yen, viewed as a “safe haven,” strengthened. In addition, stocks dropped globally, especially in the European Union and the U.K. As the yen strengthened, share prices of Japanese stocks softened, especially of exporters, and European financials were particularly hard hit.
I have often written about the opportunities that arise when price movements vary greatly from changes in underlying intrinsic value. In fact, I wrote one year ago:
“During the first two days after the vote, the European stock index dropped just under 15%, with the European financials dropping even more. I would assert that, as often is the case, the underlying intrinsic value of the corresponding businesses did not change as drastically as the market price. In fact, this is usually the case as fearful traders and investors often sell in a knee-jerk reaction in response to any geopolitical disturbance. We believe that for real investors, it provides an opportunity. Our process is to first try to measure the true impact these events may have, if any, on the intrinsic value of the businesses we own and then to respond in a way that takes advantage of the market’s short-term fears. Again I stress the point we often make: Volatility is opportunity!”
Despite the uncertainty caused by Brexit and a recent general election in the U.K., which resulted in a lost majority for the still-governing Conservative Party, the British economy is performing acceptably well with a 2% year-over-year growth rate. To be sure, economic challenges remain, but the weaker pound sterling has aided currency-sensitive sectors such as exporters and tourism. Meanwhile, despite consumer confidence softening, strong employment has indicated that the recession many predicted has not materialized.
We used this period to actively increase our exposure to those companies that were hardest hit and where we believed the change in price was not at all reflective of the changes in underlying value. Because of this discipline, embodied in our philosophy and process, shareholders in both Oakmark International and International Small Cap have richly benefitted by earning year-over-year returns (dividends reinvested) of 40.0% and 31.6%, respectively. Though events like Brexit are often traumatic and very difficult to stomach, they can provide opportunity for those who are patient.
The Friedman Doctrine
Nobel Prize-winning economist Milton Friedman wrote the following on the topic of Corporate Social Responsibility: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” You will frequently hear from Harris Associates’ investment professionals that we want to invest with management teams “that think and act like owners.” This is why, as a professional investor who is charged with looking after my shareholders’ and clients’ wealth and savings, I find it distressing when corporate boards and managements get distracted from their role of maximizing shareholder value.
A recent example of questionable corporate stewardship occurred when the Board of Directors of Akzo rejected multiple offers by PPG to purchase the company at a greater-than 50% premium and what appeared to be a generous valuation of the Akzo business. Unfortunately, Dutch corporate governance rules do not allow for the direct election of directors by shareholders, thereby insulating managements and boards from the consequences of pursuing actions that lead to value destruction.
Sadly, the Netherlands isn’t the only example of countries that support polices that inhibit shareholder value creation. In Japan, for example, hostile takeovers are nearly impossible because corporate Japan often uses cross-shareholdings and other methods to “circle the wagons” around weak corporate characters, which prevents positive change. As a result, there has been a wave of value destruction throughout corporate Japan. In addition, outside groups, consulting firms and some non-profits have recently begun to exert pressure on corporate boards and managements to make decisions that reflect their own needs, values and causes, but often are to the detriment of shareholders and long-term value creation.
Clearly, we desire the companies in which we invest to be good corporate citizens. But this is different than succumbing to the wishes of those who often possess conflicting demands based on their pet causes. Often, those we expect to stand up to this new class of bullies would rather cave in to their pressure than do what is right for shareholders. This can make our job more difficult, given our focus on boards and managements that are committed to putting their shareholders first, but it may also lead to opportunity as the quality managers who reject a “shareholder-second” (or third- or fourth-) mentality means we have a rich target for investment opportunity.
We, to the best of our ability, will continually search for and invest in companies that are committed to a Corporate Social Responsibility policy that aligns with Milton Friedman, putting shareholders first and behaving in a responsible manner. Again, thank you for your continued confidence and support.
David G. Herro, CFA
View other commentary and letters from David here.
Average Annual Total Returns (as of 06/30/2017)
The securities mentioned above comprise the following percentages of the Oakmark International Fund’s total net assets as of 06/30/17: Akzo Nobel N.V. 0.4% and PPG Industries, Inc. 0%.
The securities mentioned above comprise the following percentages of the Oakmark International Small Cap Fund’s total net assets as 06/30/17: Akzo Nobel N.V. 0% and PPG Industries, Inc. 0%.
Click here to access the full list of holdings for The Oakmark International Fund as of the most recent quarter-end.
Click here to access the full list of holdings for The Oakmark International Small Cap Fund as of the most recent quarter-end.
The quoted passage is taken from Capitalism and Freedom by Milton Friedman, 1962.
Portfolio holdings are subject to change without notice and are not intended as recommendations of individual stocks.
Investing in foreign securities presents risks that in some ways may be greater than U.S. investments. Those risks include: currency fluctuation; different regulation, accounting standards, trading practices and levels of available information; generally higher transaction costs; and political risks.
Oakmark International Small Cap Fund: The stocks of smaller companies often involve more risk than the stocks of larger companies. Stocks of small companies tend to be more volatile and have a smaller public market than stocks of larger companies. Small companies may have a shorter history of operations than larger companies, may not have as great an ability to raise additional capital and may have a less diversified product line, making them more susceptible to market pressure.
Oakmark International and Oakmark International Small Cap Funds: The Funds’ portfolios tend to be invested in a relatively small number of stocks. As a result, the appreciation or depreciation of any one security held will have a greater impact on the Funds’ net asset value than it would if the Funds invest in a larger number of securities. Although that strategy has the potential to generate attractive returns over time, it also increases the Funds’ volatility.
The discussion of the Funds’ investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds’ investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.